Quantifying the Rationale for “Watchful Waiting”

February 6, 2016

Macroeconomists and central bankers tend to characterize the economic outlook in terms of the most likely path that the economy will follow. Such an approach may be reasonable during “normal times” when the uncertainty around that benchmark path looks roughly like a “bell curve” with a single peak. At the current juncture, however, this does not provide a satisfactory characterization of the U.S. economic outlook. Rather, the most recent data have underscored the plausibility of two distinct scenarios: (i) the economy is resilient enough to keep generating gains in employment and wages, and (ii) the economy weakens further and slides into recession. Analysts have diverse views about the relative probabilities of these two scenarios, ranging from a 50-50 coin toss to something like a 1-in-6 roll of the die. But the crucial point is that both scenarios are now plausible, and further data will be needed over coming months to determine which scenario is materializing. Consequently, there is a strong rationale for the Federal Reserve to engage in “watchful waiting” along the lines suggested last week by Lael Brainard, a voting member of the Fed’s monetary policy committee. Indeed, it would be very sensible for Fed Chair Yellen to elaborate on that approach in her congressional hearings later this week.

   Employment.  Although the labor market has expanded by more than 5 million jobs over the past couple of years, the economy has not yet reached full employment. The Congressional Budget Office’s latest assessment indicates that 1.7 million Americans are currently out of the labor force (neither working nor actively searching for a job) but are likely to rejoin the labor force as the economic recovery continues. In addition, the incidence of involuntary underemployment remains elevated compared with its pre-recession average, representing an additional shortfall of about 700,000 full-time equivalent (FTE) jobs. All told, the employment gap is now equivalent to about 2.4 million FTE jobs. CBO analysis indicates that payroll growth of about 60,000 jobs per month is needed simply to keep pace with longer-run demographic changes. Thus, if the economy could maintain the recent pace of monthly job gains, then the employment gap would be practically eliminated by the end of this year. However, such a prospect now seems quite unlikely, because the deceleration in global growth and the tightening of financial conditions -- including wider risk premiums and tighter bank lending standards -- will almost surely restrain the pace of business spending and hiring over coming quarters. Thus, the most plausible benign scenario is that the economy exhibits enough resilience to keep generating payroll gains of around 160,000 jobs per month, as in last Friday’s employment report. As indicated by scenario #1 in the chart above, that trajectory would substantially reduce the employment gap this year, but the economy wouldn’t reach full employment until late 2017. Conversely, as indicated by scenario #2 in the chart, the onset of a mild recession would likely be associated with declining payroll gains and move the economy further away from full employment.

   Nominal Wages and Inflation. The average hourly earnings of production and nonsupervisory workers decelerated sharply during the recession and then remained at a plateau of around 2 percent in spite of the strengthening job market. As my Dartmouth colleague Danny Blanchflower and I pointed out last spring, this pattern was consistent with other evidence of downward nominal wage rigidity, which essentially flattens out the “wage curve” at high levels of labor market slack. Moreover, our analysis indicated that nominal wage growth would pick up noticeably once the employment gap diminished further, and that’s exactly what’s been observed more recently. Indeed, for the year 2015 as a whole, the average employment gap was about 2.5 percent of the potential labor force, while nominal earnings increased 2.6 percent. As shown in the accompanying chart, that outcome is precisely in line with the implications of the wage curve fitted to the previous data from 1984 through 2014. In the benign scenario where the employment gap narrows further over coming quarters, this wage curve implies that earnings growth will move up into the range of 3 to 4 percent. As Fed officials have noted, that prospect would likely be associated with moderate upward pressure on prices, thereby fostering the convergence of inflation to the Fed’s 2 percent objective. Such developments might well call for some further monetary policy tightening later this year. Conversely, in the adverse scenario where the economy slides into a recession, nominal wage growth would likely drop back to its 2 percent plateau, and inflation might fall even further short of the Fed’s objective. In that case, it could become imperative for the Fed to provide additional accomodation to help ensure that a mild recession didn’t evolve into something worse.

   Implications for Fed Policy. An approach of “watchful waiting” should not be equated with passivity or complacency. Rather, the Fed’s communications should keep financial market participants alert to the implications of the benign scenario in which economic conditions warrant some further rate hikes later this year. At the same time, the Fed must move expeditiously to formulate and communicate its contingency plans regarding the specific policy tools that would be deployed under adverse conditions. In effect, the Fed should be subjecting its own monetary policy strategy to the same sort of “stress testing” that is already mandatory for the systemically important financial institutions that it oversees. 

Andrew Levin is a professor of economics at Dartmouth College. Previously, he spent two decades on the staff of the Federal Reserve Board and was a special adviser to the Board on monetary policy strategy and communications from 2010-2012.